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KBAL earnings call for the period ending March 31, 2020.

Contents:

Prepared Remarks

Questions and Answers

Call Participants

Prepared Remarks:

Operator

Good morning, ladies and gentlemen. My name is Howard, and I will be your conference call facilitator today. At this time, I would like to welcome everyone to the Kimball International Third Quarter Earnings Conference Call. [Operator Instructions]

As with prior conference calls, today's call, May 6, 2020, will be recorded and may contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from the forward-looking statements. Risk factors that may influence the outcome of forward-looking statements can be seen in the Kimball International Form 10-K.

During today's call, the presenters will be making references to an earnings slide deck presentation that is available on the Investor Relations section of Kimball International's website.

I would now like to turn the call -- today's call over to Kristie Juster. Ms. Juster, you may begin.

Kristine L. Juster -- Chief Executive Officer

Good morning, everyone. We appreciate the opportunity to share with you our third quarter results, the COVID-19 impact on our operation, and discuss our business outlook.

Before reviewing our results, I wanted to take a moment on behalf of Kimball International to express our sincere appreciation to all the healthcare and essential workers on the frontlines serving this crisis. We hope you know that you are making a difference every single day. And our thoughts are with those families directly impacted by the pandemic. As I am sure we all feel, it is the incredible signs of hope and caring that give us much confidence in our tomorrow.

I would also like to recognize the employees and leadership team at Kimball International for their dedication to keep our people and our communities safe during this unprecedented crisis. The team took swift actions that are outlined on Slide 3. Our plan has been designed around the key issues facing key stakeholder groups, namely our employees, our customers and the communities in which we operate. At the onset of COVID-19, we immediately put in place a dedicated task force to implement our sanitization, social distancing and response protocols at all facilities, and adopted teleworking protocols for our professional staff, including training and full video conferencing capabilities. We also took steps to care for those at higher risk of getting sick from COVID-19 through our special care program and also, those experiencing unique hardships through a dedicated employee funds. Additionally, we made important temporary shifts in our business operations to prioritize critically needed healthcare industry products for the crisis.

Our teams also quickly came up with new ways to serve the immediate need for personal protective equipment. Today, we have manufactured over 7,000 reusable face masks and 10,000 face shields. I am pleased to say we have been able to provide PPE for our entire manufacturing workforce, as well as for healthcare and government workers and nursing home residents in our communities.

Moving on to our financial results. On Slide 4 is a summary of our third quarter performance, reflecting this continued success of our transformation program designed to generate sales growth, while yielding significant cost savings. Revenues for the period were modestly ahead of last year's third quarter on a reported basis. We had approximately $18 million in revenue that was originally scheduled to ship during the third quarter, but was paused out to future quarters due to COVID-19. Approximately $7 million was related to the closing of our manufacturing and warehouse facilities the last two days of March to accommodate the shift production of healthcare products. This product will be shipped in the fourth quarter. The remaining were shipments that were postponed by hospitality customers are pushed out due to supplier delays as a result of this COVID-19 crisis. These orders are deferrals that will move into future quarters.

Despite only a modest revenue increase, we were able to expand gross margin by 210 basis points due to the execution of price increases and savings from our transformation plan. This performance combined with only a slight increase in adjusted selling and administrative expenses resulted in a significant operating leverage, driving a 19% increase in net income and a 23% increase in adjusted EPS.

Slide 5 outlines the four pillars of our Kimball International Connect Strategy. The first is to create a winning corporate culture, inspire our people. And I can tell you that throughout this COVID-19 crisis, it is our people that have inspired us by their agility and innovative ways, all in full support of their colleagues, this Company, our customers and our communities. The next pillar is build our capabilities by establishing center-led functions and developing world-class ways of working. In January, we announced the decision to form global operations into one function at Kimball International. During the pandemic, we have seen the power of this team and the speed and efficiency at which we can operate.

Our third pillar, fuel our future, is the foundation of how we are executing on our transformation cost savings plan. Through our rigorous program management and funnel approach, we have successfully implemented projects in automation, facility optimization, and value engineering, delivery $7.2 million of transformation savings in the third quarter.

Accelerating our growth is our fourth pillar. Last earnings call, we shared our confidence in delivering growth in Q3. I am pleased to say without the approximate $18 million impact of COVID-19, all three businesses would have contributed significantly to the growth. Our innovative new workplace products continue to be in strong demand, which increased to 29% of total commercial and institutional sales, up from 27% in last year's third quarter.

Before reviewing our current position with respect to COVID-19 impact on our business and our post-COVID-19 opportunities, I will ask Michelle to briefly review our third quarter financial performance. Michelle?

Thanks, Kristie, and good morning, everyone. I will give you a more detailed overview of our solid financial performance in the third quarter of fiscal 2020, as well as share some information on our strong liquidity position. Sales this quarter increased to $178.2 million. However, as Kristie mentioned, we had approximately $18 million of COVID-related impacts relating to shipments pushed to future quarters. Even with these push outs, we had year-on-year growth in our commercial markets and the healthcare and educational verticals in our institutional market.

As you've probably noticed in the release, we changed the way we are reporting our revenue breakdown by combining several of our reported vertical into three end market categories, which we believe help simplify our messaging. The commercial market is now comprised of both commercial and financial markets and we have grouped the healthcare, education and government verticals together as the institutional market. Together, these two markets account for approximately 75% of our revenues. The third market is Hospitality, which represents the remaining 25%. Our institutional and commercial markets delivered 4% and 5% growth over the last year's quarter, respectively, while sales in the Hospitality market declined 10% when compared to the third quarter of 2019, due to shipment push outs related to the COVID-19 health crisis.

Gross margin expanded by 210 basis points year-over-year to 34%. This is our sixth consecutive quarter of year-over-year gross margin improvement. The third quarter's positive performance was mainly attributable to additional cost savings from our transformation plan, as well as higher pricing on selected product lines.

Reported selling and administrative costs of $45.6 million, were down $1.9 million, also declining as a percentage of sales by 120 basis points to 25.6%. On an adjusted basis, excluding CEO transition costs and the impact of our Supplemental Employee Retirement Plan, selling and administrative expenses increased 40 basis points to 26.5% or by $1 million to $47.2 million despite our continuing investments in growth initiatives this quarter.

Net income increased 19% to $9.5 million or $0.25 per diluted share.

Adjusted EPS increased 23% to $0.27, compared to $0.22 a year ago.

Adjusted EBITDA was up 21% to $17.5 million and resulted in a margin of 9.8%, up 160 basis points versus a year ago quarter.

Turning to our cash flow performance. We generated $4 million in cash flow from operations. Capital expenditures during the quarter were $5.6 million, most of which were related to manufacturing equipment upgrades to increase automation and our facility upgrades. We returned $5.1 million of capital to shareholders during the quarter, including $3.4 million in dividends and $1.7 million in share repurchases executed in the third quarter. We are temporarily halting share repurchases to preserve cash in light of the uncertain economic conditions. Return on invested capital for the quarter sits at 29.4%. Growth in earnings and discipline in investing our capital over the years have contributed to this impressive performance and we continue to rank among the best-in-class on this metric relative to our public office furniture peers.

We've spent a tremendous amount of time running multiple financial scenarios using various assumptions around the length and depth of the impact of COVID-19 on our business. In general, our contribution margin is around 30%. So, on incremental revenue changes, we would expect decremental margin at approximately that rate, assuming no actions taken. We are scaling back discretionary expenses and evaluating additional actions for fiscal year 2021 as we prepare for near-term uncertainty and make strategic choices to enable our ramp back up as we navigate through this crisis.

We are confident that our strong financial position and financial discipline will enable us to weather the current economic situation. We have a strong balance sheet with $90.3 million in cash and cash equivalents, as well as an additional $73 million in available credit lines.

I will now turn the call back to Kristie to provide further insight on our path forward. Kristie?

Kristine L. Juster -- Chief Executive Officer

Thank you, Michelle. We are all facing an uncertain economic environment, but at Kimball International, we have the benefit of our ongoing cost savings that we have derived from our transformation plan, and a strong balance sheet that affords us to stay in power to weather the storm, all while continuing to invest in our future.

Slide 9 provides an update on where we stand today. Currently, we are operating in eight of our 10 US plants, which equates to about 95% of our total manufacturing footprint. However, because we are currently operating with a reduced workforce in light of our commitment to keep our employees safe, our manufacturing facilities are running at about a 60% to 65% of our normal run rate. While continuing to prioritize all healthcare orders, we are now able to service all end market orders. Recently, order rates have softened throughout the month, with our commercial and institutional markets down 23% from year ago end of April levels, and a 78% decline in orders to our Hospitality vertical. While there is consistent quoting activity in the commercial market, delivery schedules vary depending on the impact of state mandates. Mitigating this impact is our strong backlog, which amounted to $187 million at the end of the third quarter, approximately $100 million of which is scheduled for delivery in the fourth quarter. We also expect to derive additional cost benefits from our transformation plan during the fourth quarter.

Kimball International entered this crisis period in a strong position with diversified end markets and significant manufacturing agility that enable us to efficiently ship production to those products that are in higher demand. As Michelle noted, we have substantial liquidity to cover our needs. That said, we need to anticipate tough times ahead, and have taken additional steps to reduce our cost structure and preserve our strong liquidity position. These include cutting our anticipated fourth quarter capital expenditures by 50%. We are also reevaluating our spend for fiscal 2021, carrying back discretionary spending and closely managing our inventory levels to reduce working capital requirements. We've also made the decision to temporarily suspend our share buyback program. There are additional levers that we have identified and are closely monitoring market conditions.

Given the uncertainties surrounding the short-term economic conditions, we considered to pull back on the loans from financial targets we have set forth for the fiscal 2020 through 2022 time period. That said, we are confident that once a recovery sets in, our Company has the structure in place to achieve consistent mid-single-digit revenue growth and grow adjusted EBITDA and EPS at a faster rate than sales.

Looking to the medium- and long-term, we believe that this health crisis will cause many changes in the workplace environment that will provide additional opportunities for Kimball International to gain market share, leveraging our investments in innovation, flexible manufacturing and rapid time to market.

On Slide 10, we have provided our thinking on several aspects of the shifts in our new workplace and are actively utilizing these insights to inform our future planning. First, social distancing will make the workplace more fluid. It will be in the office, at-home and anywhere in between. Second, hygiene requirements will be paramount, which will require changes in the way we design and manufacture products. Third, design thinking is critical and the redesign to develop creative solutions for professional and personal workspaces. Fourth, B2B will look like B2C, providing a tremendous opportunity for incremental sales through e-commerce channels. Our recent launch of the Etc. sub-brand of National is a strategically important step for us in this direction. And fifth, technology enablement will accelerate with the increase of virtual school, work, telehealth and showrooms.

To sum up, Kimball International's strong balance sheet and newly optimized operating model provide us to stay in power to manage through the crisis. And quickly benefit from improved economic conditions. And while we are planning for a market impact, we also have an eye on the opportunities ahead.

Operator, now I would like to open the call to questions.

Questions and Answers:

Operator

Yes, ma'am. [Operator Instructions] Our first question or comment comes from the line of Greg Burns from Sidoti & Company. Your line is open.

Gregory Burns -- Sidoti & Company, LLC -- Analyst

Good morning. I just had a question about the decremental margins you mentioned and the -- maybe projected cost savings. I know you had some cost savings that you had previously laid out as part of your Kimball Connect plan. Maybe you could help us quantify what you've achieved so far and maybe what you still expect to gain in the fourth quarter? And then, is there any way you can maybe quantify some of these incremental items that you're talking about in terms of potential cost savings and tie that back into the decremental margin that you mentioned, the 30%? Should we assume that that is kind of the base case with maybe potential improvement or improvement based on some of these incremental items you're discussing? Thanks.

Kristine L. Juster -- Chief Executive Officer

Thanks, Craig. It's Kristie. So, let me start by saying, in our journey, pre-COVID, we've made significant progress on our gross margin expansion and that's been driven -- a significant portion of it has been contributed by our transformation savings. And that we believe is sustainable in nature, and Michelle talked about the six quarters of that. We -- as we look at going forward, we have been actively working on the funnel for additional transformation cost savings. So, that program and that work is very much intact, and we have been working on that diligently through the crisis period.

As we look to additional levers or kind of the pandemic in kind of the space that we're in, we are cutting discretionary spending in some -- making some prudent capex decisions to make sure that we can kind of endure for whatever is ahead. So, we really are looking at it in two very separate ways, and I'll let Michelle kind of comment on how that ties into our perspective for the full-year.

So, great. We had about seven -- a little over $7 million of additional transformation savings in the quarter. Now, some of that transformation savings is variable cost and some of it is fixed cost. But in the 30% contribution margin, that was on a contribution margin level, the 30% that I mentioned, that is assuming -- I mean, that's as of today. So that includes the transformation savings that we've seen to date. But as we go forward and we identify additional actions for fiscal year '21 that would be -- that would not be included in that 30%. So the 30% is as of where we are today. And again, as we're looking at transformation savings, part of the transformation savings is in the fixed costs and part of it is in variable.

Gregory Burns -- Sidoti & Company, LLC -- Analyst

Okay. And then you mentioned you had a pretty healthy backlog. So when you think about the fourth quarter, orders are obviously trending down 25 percentage range for part of the business and 78 in Hospitality. But should we -- will revenue maybe be down less that what orders are trending? How should we think about that dynamic? Because it seems like you have a pretty good visibility on a good part of the business based on the backlog. But what -- how will that dynamic play out in the fourth quarter between kind of the trends you're now seeing in the early part of the quarter versus some of this backlog that you've built up?

Kristine L. Juster -- Chief Executive Officer

Right. Right. You're right. We came into the quarter with a very strong backlog. And then just to remind you, we have the two days of pause that we created as well, that pushed some of the volume into the Q4. And what our challenge was in the Q4 was the fact that we were actually -- facilities were shutting down and we were ramping them up back and prioritizing healthcare orders and only servicing essential orders. We have -- so we've gotten our facilities back up to -- we commented on about the 65% rate and we feel really good about how the facilities are ramping back up, the social protocols and -- that we put into place. And so, we are seeing ourselves kind of ramped back out. And so, the Q4 is going to be impacted by more from our ability to ramp our manufacturing facilities than new orders.

Gregory Burns -- Sidoti & Company, LLC -- Analyst

Okay.

Kristine L. Juster -- Chief Executive Officer

We have also replanned all of the orders in the Q4 time frame and are working through that. And Michelle, I welcome you to comment as well.

Yeah. So we had disclosed in our press release also, Greg, that of that $187 million of backlog, about $100 million of that would ship we thought in Q4 or we anticipate. We did see some push outs from, particularly Hospitality customers. And some of those push outs do go beyond Q4. So, some of that backlog that you see at the end of March will hit in future quarters as well.

Gregory Burns -- Sidoti & Company, LLC -- Analyst

Okay. And then specifically to the Hospitality market, can you just help me better understand the makeup of that market? How much is project-based versus maybe day- to-day, like refurbishment-type business? Because I would assume like the -- some of the large projects that are -- have been started, they have to be completed and furnished. But maybe you're seeing more of the delays on the day-to-day. Can you just talk about maybe the dynamic of that market and how that -- how you see that evolving over the next few quarters?

Kristine L. Juster -- Chief Executive Officer

Sure. So, in the hospitality market, the majority of our business in Hospitality is renovation, and it is on a project basis. So there is very little day-to-day business that really sits in the hospitality spectrum. On the orders that we have seen, the impact on the Hospitality business is a delay and a push out in orders. We have not seen cancellation in orders. And we are just seeing a difference in timing in the orders that we've had in our backlog. And, as you know, we were very strong in hospitality and had quite a few orders positioned for the back half of the year. And so, we do servicing -- we do see servicing that order base, that backlog throughout multiple quarters. But we have not seen any cancellations to date. And we are seeing some of the end users wanting to accelerate the renovations as the occupancy is light due to the crisis.

Okay. And then you have the slide mentioning some of the -- your insights on post-COVID and the opportunities there. But there is -- I guess, competing dynamics where maybe companies are more comfortable working remotely and that has been working for them, so maybe they'll be using less office space, but then there's -- they also need to kind of reimagine maybe -- or do certain things to their current office to make it safe, safe for their employees in this environment, so they have to maybe do light renovations or reconfigure footprints and things like that. So, how do you see the pluses and minuses, positives and negatives for Kimball in this type of environment or the office market in general? And then what kind of capabilities or differentiations does Kimball have that maybe, plus you think that you'll be kind of successful and maybe gaining more share or growing in this post-COVID environment?

Kristine L. Juster -- Chief Executive Officer

Great. Yeah. Greg, thank you. We think there -- and we see three choices for the corporations that are dealing with professional workplace. There is a kind of redo immediately, and I would call that a retrofit. There is a redesign for social distancing and there is really an implementation around work from home. And in our dialogue with end users, they're really activating on all three. And what we're seeing is a tremendous amount of activity in dialogue into the reentry of the professional workforce and kind of taking a shorter term redo retrofit concept and then moving into a bit of redesign and enabling the work from home guidelines that are going out in many corporations.

I believe wholeheartedly that we are situated to service all three of those. We have -- we actually are using the reentry of Kimball International, we talk about the fact that we've completely redone our headquarters. We are using our own facility and our own personal reentry as a guideline for what we're putting out in the market. And we have groups working on kind of near-term retrofits that are really around shields and kind of easy installs in existing products. We have groups working on mid-term that are new products, that are about wellness stations and new finishes that are ease of cleaning, and then we have longer term innovation. And then ultimately, we started our e-commerce build and that will be a critical component of work from home.

So I do think we are situated to help all of our end users through these changes. And I very much have been tremendously impressed with the agility of this organization during this crisis. And I'm very, very pleased on how we're reorganizing our product roadmaps and our priorities in order to address this opportunity in the market. So, I think it will impact us dramatically. I think there is opportunities, and I think end users will be looking at it very differently.

And I feel like -- if you think about what's different about Kimball International, we are on the front-end of our transformation journey. So, we talked about the fact that all of our cost-out endeavors are in service to growth, and we have just started those investments. And so, we have the opportunity to deliver cost savings. We have the opportunity to take hold in some of our new initiatives like healthcare. And we have just started the work on our global operations. So, we have a significant opportunity going ahead, not only in our own efficiency, but in new ways to service the market.

Gregory Burns -- Sidoti & Company, LLC -- Analyst

Okay, great. Thank you.

Operator

Thank you. [Operator Instructions] Our next question or comment comes from the line of Tom Maher from Hilton Capital. Your line is open.

Thomas Maher -- Hilton Capital Management LLC -- Analyst

Thank you. Hi, good morning. I have a short-term question and then maybe a longer-term one as well. In the short-term, given that we're probably going to see lower activity levels here, I'm just kind of curious how you see that flowing through working capital and if that's going to free up some cash for the Company?

And then my longer-term question was, and I apologize for my ignorance, but in terms of your manufacturing capabilities, how fungible is it if the demand is coming from the different parts of your mix, meaning if some of the hospitality doesn't come back, but maybe seem stronger in the institutional space. Can you kind of shift over your manufacturing to meet that demand? Or is it a little bit harder to do than that? Thanks.

Kristine L. Juster -- Chief Executive Officer

Great, Tom. Thank you for the questions. Michelle, do you want to take the question on working cap first and then I'll go over to longer-term manufacturing footprint?

Yes, I will. Thanks for the question, Tom. So, as we're looking at our working capital, absolutely, it's something that we are very focused on with the economic conditions. So, we do anticipate and we are seeing a little bit already, where we're having some customers asking for extended lead time, so -- on payments. So, we are working through that with our customers. We're working through that on a case-by-case basis. But we've put some new processes in place to really help us focus on collecting our receivables and then inventory as well with the downturn in the orders that we saw in April. We've got to really focus on our inventory. And so, we -- again, we've put different processes in place. We're looking at our stocking levels, reducing our stocking levels. And just looking at everything to ensure that we keep a real focused manage on our working capital as we go through this crisis.

Thomas Maher -- Hilton Capital Management LLC -- Analyst

Got you. And just -- maybe just a quick follow-up on that. In terms of the way that you had to move the mix, given the sort of immediate reaction here to COVID. Did that cause any inefficiencies in the manufacturing? I mean, by sort of changing how the orders were slotted to get some of that healthcare out first and maybe take some of the hospitality out of the mix?

It did, yes. We have four -- initially only four of our 10 manufacturing facilities were open and we're back up to eight now. So we did have to do some reshuffling and we didn't have full workforce. So it did cause some inefficiencies until we got all of that situated and running properly.

Thomas Maher -- Hilton Capital Management LLC -- Analyst

Great, thanks. And then just on the longer-term sort of fungibility of your manufacturing?

Kristine L. Juster -- Chief Executive Officer

Great. Yeah. Let me speak to that. So, in January, we announced going into a global operation structure. Previously to that, how we would -- three dedicated business unit that had their own manufacturing footprint. All three of our businesses are in commercial furniture -- commercial or professional-grade furniture. And with the decision to go to a global operations, there is significant opportunity in facility optimization in regards to the flexibility of where our products can be manufactured. And so, we have started that work and we have a plan in place. And we know there is tremendous opportunity and we do have the agility to move product throughout the manufacturing footprint. Just an example of that, we had bought that David Edward poster facility -- seating facility more dedicated to the Kimball brand. But since we've made this decision, we're moving product through there that's both Hospitality and Kimball-branded products. So we're pleased with the opportunity to do that. There are many light processes and actually products that are being made in multiple facilities that we are now reorganizing for optimization going forward.

There -- yeah. I was going to say, there is one thing that I would add to that. Tom had asked about Hospitality, too. Maybe just mention that. Our Hospitality -- about 75% or so of our Hospitality is purchased through supply partners. We don't actually manufacture. So it's more of a variable model on the Hospitality side.

Thank you. Our next question or comment comes from the line of Alison Peck from Peck Wealth. Your line is open. Ms. Peck, you may need to unmute your phone.

Alison Peck -- Peck Wealth Management, LLC -- Analyst

Hi. This is Alison, and thank you for taking my call. I'm new to your -- the idea of your Company and finding this call to be very interesting and I'm impressed with how you're managing and challenging -- this very challenging time. My question has to do with your positioning from a competitive standpoint, in terms of -- you've addressed some of this already, so please -- don't repeat yourself. But in terms of your flexibility to adjust from a design, manufacturing, marketing and expense standpoint. And then, finally, would be -- my question has to do with your main competitors and your market share positioning.

Kristine L. Juster -- Chief Executive Officer

Sure. Alison, thank you for listening in on the call. We appreciate it. Let me start from our market positioning for a moment. So, we have three brands: the Kimball brand, the National brand and the Kimball Hospitality brand. And we have made some very distinct choices within those -- that brand portfolio. So, one is that the Kimball brand is focused on the healthcare arena. Two is that the National brand is really focused on the ancillary product categories. And then we have our Hospitality business that makes kind of, I'll call it, Hospitality-grade or professional-grade products. And that gives us a lot of flexibility in the market. The difference that I feel from some of our peer set is that, we've made distinct choices as to which markets that we are servicing in the total landscape of commercial furnishings. And we've made tremendous progress in each one of those markets.

And so, I really like the choices that we've made. I know, certainly, through this crisis the Hospitality business is the most impacted of our businesses. Michelle commented that that is also our most valuable business, not only from a manufacturing standpoint, but that business also goes through manufacture -- sales reps. So our selling side is also a variable on that business. And that business is 100% domestic. And so, we service all of the US hospitality sector. So, I feel with our healthcare, our ancillary focused and our Hospitality, we are well served by the long-term success of this business.

I also believe we're at a very different place in our evolution as a Company. We just started our transformation. Year and a half ago, we were three distinct businesses and we did not have the agility that I spoke to earlier. And so, today, we run under one corporate strategy, and we have the opportunity to resources and investments, and now with global operations product based on where the demand is and where we see the opportunity in the future. And so, with our size of business and our agility, we feel like we have the opportunity to really flex to the new workplace that we're very excited about in the future and certainly playing a role in thought leadership in that.

Alison Peck -- Peck Wealth Management, LLC -- Analyst

That's very helpful. Thank you.

Kristine L. Juster -- Chief Executive Officer

Thank you.

Operator

Thank you. I'm showing no additional questions in the queue. At this time, I'd like to turn the conference back over to management for any closing remarks.

Kristine L. Juster -- Chief Executive Officer

Thank you very much. I'd just like to say, on behalf of Kimball International, we very much appreciate you listening to the call, and we wish everybody a safe and well path ahead. Have a nice day. Thank you.